If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investing are in my book “Stairway to Wealth” available at www.lulu.com
A correspondent recently presented the question: should she buy her next building in a bread ‘n butter area and benefit from a higher cash flow, or should she buy in a higher income district, barely break even, but have the possibility of greater appreciation?
Well, at one level it doesn’t make much difference. Money can be made either way. Within limits, the dominant force that determines the success of (almost) any hypothecatable (hypothecate: to borrow against) investment is not where it is located but rather what happens with interest rates after you buy. The reason is simple: given a fixed payment, as rates go up the amount you can borrow or refinance goes down. Alternatively, as rates go down, the amount you (or the person who buys from you) can borrow or refinance goes up. That means gains from appreciation are largely interest rate driven. Since we have no direct influence over interest rates, the market value of our investments is to a significant degree beyond our direct control.
Sidebar – It’s generally more important to gain from appreciation than from equity build-up. The maximum you can benefit from equity build-up is 100% of the loan amount. The maximum you can benefit from appreciation is many multiples of the original market value. As an example, my husband once told me that when he was just getting into investment real estate you could buy blue collar properties for under $15,000 a unit. Now, of course, even the most basic properties are well over that. Appreciation is important.
Sell and pay taxes: We need to get the down payment for our next building out of our current building. We can do this either by selling, exchanging, or refinancing. If you sell there is an immediate tax on the capital gains. If you exchange you defer the taxes until later (check with your CPA for details). If you refinance, you don’t pay a tax on the amount you borrow. You may be taxed down the road (mortgage over basis), depending on what the Tax Code requires at that point, but there is no immediate tax when you borrow the money.
Exchanging: We hear a lot about IRS 1031 Tax Deferred Exchanges as a way to defer the payment of taxes, but (again, CPA time) many of the same benefits accrue to the folks who simply refi their old building and pull some cash out. Plus, if they refi they wind up with two buildings, their current one and the new one. If they sell or exchange they lose their current building and finish the process with only the new building.
Structurally, what is the difference between a tax deferred exchange and a sale? If you attempt an exchange you must identify your new property by a certain date and take title not too long after that. If you can’t find a new qualifying property you want, or either your buyer or the new seller can’t perform in time allowed, you could have a mess on your hands.
Ok, how about the difference between a sale and a refi? First, you will probably get more cash money (before paying the taxes due on sale) from a straight sale. Note: that doesn’t mean your net benefit will be greater. We’ll talk more about this in a moment.
Secondly, a refi will almost always give you less money than a sale, but you won’t sell your original property so there will be no capital gain taxes due. And, counterintuitively, a refi may benefit you more than either an exchange or a sale.
In the final analysis, you are the private “money manager” solely responsible for growing your net worth. If that is your goal you will probably find that you may control more dollars under management if you never sell. You just refinance and buy another. Not all the time, but more times than not, refinancing an existing property and using the proceeds to buy the next property works out better than either a tax deferred exchange or a sale.
Sale / Refinance Example:
This hypothetical example assumes an existing loan equal to 40% of property value.
Sale or Property value $1,000,000
Exchange Haggle discount @ 5% ($50,000)
Commissions @ 6% of pur. price ($60,000)
Closing Costs @ 1% of pur. price ($10,000)
Existing loan payoff ($400,000)
Prepay fees Assume -0-
Balance to owner $480,000
Refinance Property value $1,000,000
Haggle discount -0-
New loan @ 65% LTV $650,000
Commissions @ 1% of new loan ($6,500)
Closing Costs @ 1% of new loan ($6,500)
Existing loan payoff ($400,000)
Prepay fees Assume -0-
Balance to owner $237,000
Sale / Exchange Thoughts:
Right now the market favors 33% down payments. If you sold your (hypothetical) $1,000,000 building you would have enough money from the sale to buy a replacement of about $1,440,000 ($480,000 x 3 = $1,440,000). Due to leverage you would increase the value of your apartment assets by somewhere around 45%.
But . . . you originally had an equity account of $600,000. Now that you sold the original building and bought another one you have only $480,000 in equity. Yeah, you may have more “dollars under management” but your total equity has dropped. You have less money.
In this example, the net from refinance is estimated at $237,000. That’s a lot less than you’d get from a sale and would permit the purchase of an additional building of only about $700,000. Remember, one-third down. You used to have a million dollars worth of apartments and a $400,000 loan. You had $600,000 equity. Now you still have your original $1,000,000 building but it has a new $650,000 loan, so you have only $350,000 equity.
However, you’ve bought an additional building and you have $237,000 equity in it. You have a total of $587,000 ($350,000 + $237,000) equity in your buildings. Instead of selling, if you refinanced you’d wind up with $1,700,000 of property (original $1,000,000 plus new $700,000 property). You have a bigger property base and you suffer no material drop in your total equity. You still have very nearly the same money.
Now, it doesn’t always work out as favorably as this, but it often does. If you’re curious, call me and we’ll talk.
Ok, but once our correspondent refinances, should she buy a bread ‘n butter building or a trophy property? The reason this is an important question is that even though interest rates may go up or down on an across-the-board basis, their effect might be different between basic buildings (bought for cash flow) and franchise buildings (purchased for appreciation).
At this level, it really does make a difference where you buy. If you purchase where buyers expect a high cash flow as the primary purchase incentive, you will more than likely have to provide a high cash flow when you sell it. (The rule is: buy for cash flow, sell for cash flow.) Your basic building will almost certainly appreciate if interest rates decline, but it probably won’t appreciate as much as an investment actually purchased for appreciation. The reason is that after deducting for the next buyer’s expected cash flow (NOI minus cash flow = funds for debt service) there will be less money available for mortgage payments.
On the other hand, the price of an “appreciation” investment is based less on loan amount. Thus the buyer has to make a bigger down payment. You have to pay more down when you buy. If you ever sold, the new buyer would have to put more down. An “appreciation” investment is worth more the next time you refinance.
Assume two identical properties, each with $100,000 of annual gross scheduled income. One is in an area where properties sell on cash flow, the other one is in an area where properties sell on expected appreciation.
Cash Flow / Appreciation Example
Assumptions: The Cash Flow property presumes a 10 year hold with NOI growing at 5% annually. The Appreciation property presumes a similar 10 year hold, but NOI grows at 7% annually because property in a higher income, more desirable area can generate higher rent increases. (A desirable area has four important characteristics: increasing per capita income, increasing population, some factor that inhibits growth, and no rent control). Similarly, vacancy / debt coverage ratio / and down payment change between areas and are hypothetical. This example assumes interest rates will increase from 4.5% to 6.5% during your holding period. In both cases line items not material to the analysis are deleted. Third party costs, equity build-up, and cash flows during the holding period are not considered. All numbers are rounded.
The Cash Flow Gross Scheduled Income $100,000
Purchase Vacancy @ 7% (7,000)
Gross Effective Income $93,000
Fixed / Variable expenses @ 35% (33,000)
Net Operating Income $60,000
Debt Coverage Ratio: @ 1.25 $48,000
Loan Amount: @ 4.50% (Example) $789,000
Down Payment: 25% $263,000
Purchase Price: $1,052,000
The Cash Flow Net Operating Income $98,000
Sale Loan Amount: @ 6.5% (Example) $1,034,000
Down Payment: 25% $345,000
Sales Price: $1,379,000
Gross Gain: Sale minus old loan $590,000
Please notice a couple of things. Even though GSI starts out the same, the initial purchase prices are different. The Cash Flow property is purchased at $1,052,000 and brings in an initial $12,000 cash flow annually (NOI minus Debt Service). That’s about 5% on the down payment.
At the sale, the Cash Flow property recognizes a gross gain of $590,000. That includes the original down payment of $273,000 . . . that big check you get from the escrow girl always includes your original down payment. Folks get excited and sometimes forget that. You made $317,000 on a $273,000 investment in ten years, an appreciation of 8% annually, in addition to the cash flows.
Appreciation Gross Scheduled Income $100,000
Purchase Vacancy @ 5% (5,000)
Gross Effective Income $95,000
Fixed / Variable expenses @ 35% (33,000)
Net Operating Income $62,000
Debt Coverage Ratio: @ 1.20 $52,000
Loan Amount: @ 4.50% (Example) $855,000
Down Payment: 35% $460,000
Purchase Price: $1,315,000
Appreciation Net Operating Income $197,000
Sale Loan Amount: @ 6.5% (Example) $2,164,000
Down Payment: 35% $757,000
Sales Price: $2,921,000
Gross Gain: Sale minus old loan $1,606,000
On the other hand, the Appreciation property brought in (initially) only $10,000 of cash flow and the down payment was higher. The buyer gets only 2% cash flow ($10,000 divided by $460,000). At sale, however, she makes it all up. She gets a gross gain of $2,066,000. Take away the original down payment of $460,000 and she made $1,600,000, a return of 16% (compounded annually).
So what should our correspondent gather from this discussion? All investments will be affected by changes in interest rates, but not necessarily equally. If a cash flow property and an appreciation property are purchased at the same time – all else being equal – more money can be made from appreciation (i.e., capitalizing a higher stream of income at a lower rate) than from cash flow. All in all, it’s probably a good idea for our correspondent to at least consider investing in the better area. But satisfactory investments can be had in either case.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email KlariseYahya@SBCGlobal.net.